Puerto Rico's Tax Benefits—More than 'The Better Florida'

Source: Editors, The Gold Report (4/9/14)

Puerto Rico promises to do for Americans what Singapore and Hong Kong have done for bankers and businessmen from London. In this interview with The Gold Report, three experts with in-depth knowledge of the pros and cons of living and investing in Puerto Rico share what it is like on the ground for investors. InternationalMan.com Senior Editor Nick Giambruno and Casey Research Chief Technology Investor and Puerto Rico resident Alex Daley join Sterne Agee's Managing Director of Equity Research Todd Hagerman in clearing up some of the confusion about this "misunderstood" island and why the tax benefits for Americans make it "The Better Florida."

The Gold Report: Alex and Nick, you just co-authored a report on Puerto Rico titled "Pocket Enormous Tax Savings in Puerto Rico." Can you give us a rundown on the tax incentives in Puerto Rico?

Alex Daley: Sure. The first thing your readers should understand is that for Americans, this is truly a unique option and a tremendous opportunity for the right people.

Puerto Rico recently passed what are known as Act 22 and Act 20, or the Individual Investors Act and Export Services Act. They allow new residents of Puerto Rico to be completely exempted from Puerto Rican taxation on their capital gain, dividend and interest income. And the Export Services Act levies a top 4% tax rate on earnings from businesses that perform services, like professional consulting, asset management, research and development, computer programming, and so forth, in Puerto Rico for clients outside of Puerto Rico.

Before Puerto Rico's new laws, it was immensely difficult for Americans to take advantage of incentives like these. For decades, programs in countries like Panama and Singapore sought to attract investors with tax breaks—but Americans couldn't take advantage of them. Unlike countries in Europe, Asia and Canada, American nonresident citizens are taxed on their worldwide income. The only exceptions have been in far smaller jurisdictions—never before in a country with the modern infrastructure and a deep labor pool that Puerto Rico offers.

Todd Hagerman: In addition to Acts 20 and 22, the International Financial Center Regulatory Act, referred to as Act 273, is specifically designed to attract foreign investment outside the U.S.

Nick Giambruno: When I first heard about these tax incentives, I thought for sure it had to be something that was too good to be true. This motivated me to dig deeper. After extensive research, it became clear that the benefits were not an illusion and were 100% legitimate. For many Americans, including individuals operating on a modest scale, they are a huge opportunity that could really be game-changing. They've already helped a couple of my colleagues at Casey Research, like Alex.

TGR: Alex, tell us your rationale for moving to Puerto Rico. How is life there working out for you?

AD: I was no stranger to Puerto Rico and had been to the island a number of times previously. I had long been considering relocating to the Caribbean. Of course, Act 20 and Act 22 were a huge draw, but so is the tropical weather, beautiful white sand beaches, lower cost of living and the adventure of all of it. Just like everywhere else, of course, Puerto Rico has its negatives. Make a decision like mine and inevitably you will hear something about the crime. But to extrapolate these statistics to the entire area is a mistake. It would be similar to not moving to Michigan because there is crime in Detroit. Like any state with a dense metropolitan area, there's crime in some areas. If you steer clear of those areas or take the same precautions you would in any big city around the world, you'll be fine. In fact, one of my colleagues lives right on the beach in the touristy Condado neighborhood and just loves walking to the nice restaurants. For me, the more far-flung areas of the large island were more of a draw.

TGR: What makes these incentives in Puerto Rico different from, say, the Cayman Islands or other low-tax jurisdictions?

AD: It has better infrastructure, more familiar goods from home and because the U.S. is the only country that taxes its nonresident citizens on their income no matter where they live and no matter where they earn their money, it has huge tax benefits. This means that while a Canadian could relocate to a place like the Cayman Islands and pay zero tax, an American could not. The American would still have to pay taxes anywhere in the world by virtue of his citizenship; for Americans there really was no escape. . .until now.

"Acts 22 and 20 allow new residents of Puerto Rico to be completely exempted from Puerto Rican taxation on their capital gain, dividend and interest income."

NG: Yes, that's exactly right. Because Puerto Rico is an unincorporated territory of the U.S., it's not quite a state and not quite a foreign country; it's a commonwealth. This arrangement allows it to have a unique tax situation. Namely, Puerto Rican residents who derive their income from Puerto Rican sources do not pay taxes to the U.S. government—they pay them to the Puerto Rican government. The same is true of the U.S. Virgin Islands, for instance, in a state of affairs that has been all but unchanged since the 1950s. Combine this commonwealth status with the new tax incentives, and mainland American citizens have a window to legally lower some of the burdens of U.S. taxation. There isn't another jurisdiction in the world that offers such an opportunity for Americans. You can obtain most of the tax benefits of renunciation without giving up your U.S. passport.

TGR: Why would Puerto Rico want to make such an attractive offer to new residents?

NG: Quite simply, the Puerto Rican economy needs it. The island needs to boost its economy to reduce its debt burden, and that's what gave impetus to Act 20 and Act 22. So in that sense, Puerto Rico's economic troubles are a blessing in disguise. Puerto Rico is no novice at sculpting tax rules to attract foreign investors and expatriates. For decades, the country has offered tax incentives to many types of businesses, especially manufacturers, which is why today you'll find plants belonging to Praxair (PX:NYSE), Merck (MRK:NYSE), Pfizer (PFE:NYSE) and other big names dotting the island's interior. However, after watching India attract knowledge workers and Singapore attract asset managers, it was glaringly obvious that it could up its game and bring in less environmentally impactful businesses. After all, the populace is better educated, speaks English more fluently as a whole and doesn't have to man the graveyard shift to work with American customers due to time-zone differences. So, the government set out to attract service businesses.

TGR: Is it working? Are people taking advantage of the benefits, moving to Puerto Rico and opening businesses?

TH: The intended outcome hasn't been realized to this point. I think that part of the challenge is that Puerto Rico has been having a difficult time publicizing and promoting the various tax incentives, and, at this stage of the game, while the incentives were clearly designed to attract foreign investment largely in the manufacturing sector and facilitate job creation, they really haven't lived up to expectations. Those who have participated have been largely professional investors who put money into properties, assets and other types of alternative investments to take advantage of the act. Unfortunately, those investments, while they create tremendous tax incentives for the investors, don't create the jobs.

TGR: So will the government keep the incentives in place?

TH: It will. The legislation has been extended several times, and I believe it will continue to be extended until the government feels it is on more solid ground from both an economic standpoint, as well as an employment standpoint.

TGR: Couldn't the U.S. government force Puerto Rico to change its tax incentives?

AD: Of course the U.S. government could pressure the government here, but it likely wouldn't affect those who have already obtained the benefits. Such an action would just close it off to new participants. But we believe that is unlikely. The U.S. government understands that Puerto Rico needs to boost its economy to help it address its debt problem. Act 20 and Act 22 help the island do just that. The last thing that the U.S. government wants is a disorderly default or to have come to the rescue in the form of an unpopular bailout. As of right now, it looks like Act 20 and Act 22 are here to stay.

NG: There's also the issue of Puerto Rico becoming the 51st state or its legal status otherwise changing. That would also be something that would end the tax incentives. However, this issue has languished for decades; the Puerto Ricans themselves are divided—some want statehood, some want the status quo, and others want complete independence. I think it is very unlikely that Puerto Rico's current commonwealth status will change any time soon.

TGR: Todd, you said in a recent industry report that Puerto Rico's economic activity is stabilizing. What specific steps have had the most success in slowing the year-over-year decline in Puerto Rico?

TH: There are a couple of different things. Puerto Rico typically changes administration every four years and there is a strong correlation with declining economic activity post the election year. That is often the result of the incumbent increasing spending to improve chances of getting elected. As usual, after the last change in administration a couple years ago, we immediately saw a drop off in economic activity compared to the election year.

TGR: Are some of the reform measures, like pension reform and passing a neutral budget, working to improve the economy?

"Puerto Rico has a tremendous education system, infrastructure to support a fair amount of growth and programs that have been put in place to stimulate investment and the economy, and underlying job growth."

TH: It remains to be seen. Clearly, part of the stabilization in the economy right now reflects the fact that the employment participation rate continues to tick higher. Revenues are exceeding government expectations, largely through the immediate implementation of the corporate tax hike in July. But we probably won't see the full impact of austerity measures on consumers and small businesses until the latter part of 2014, after we've had a full year of the budget.

TGR: Are there any publicly listed stocks with exposure to Puerto Rico worth discussing?

If you wanted to make a bullish bet on Puerto Rico, Banco Popular is your safest choice. It's by far the largest retail bank on the island. It will likely be a primary beneficiary from any economic activity spurred by Act 20 and Act 22. Banco Popular has a market cap of around $3 billion, ample liquidity, a healthy Tier 1 capital ratio of 19.2%, a relatively low nonperforming loan ratio of 2.5% and is trading at 68% of its book value.

If you are more of an extreme contrarian or crisis investor, you may want to check out Doral Bank. It is one of the island's primary mortgage providers and took a huge beating last quarter as its loan book deteriorated in tandem with the general economy.

Doral's stock is down around 45% year-to-date—near 10-year lows—and is only trading at a mere 15% of its book value. Its nonperforming loan ratio is 11.3% and its Tier 1 capital ratio is 9.7%. It's definitely a very risky proposition, but it could be an interesting play for speculators looking to profit from a potential economic upturn in Puerto Rico.

TGR: Todd, you have three of Puerto Rico's banks as Buys. What are the individual catalysts for each company?

TH: The banks on the island were some of the most troubled institutions as we went through the financial downturn a few years ago. The banks in Puerto Rico were treated differently during the bailout than their U.S. counterparts. After a six-year recession, we are finally starting to see an inflection point where the credit quality at these institutions is becoming more manageable, bank capital levels have reached all-time highs and liquidity levels have improved. The underlying financial footing of each of the banks in Puerto Rico is significantly stronger than where it was only a couple years ago.

That said, these banks continue to operate under pretty close supervisory scrutiny from the various banking regulators. But we're at a point where, with credit quality becoming more manageable, companies such as Banco Popular and First Bank are in a position to exit their various regulatory agreements. Banco Popular also has Troubled Asset Relief Program (TARP) debt that was provided from the Department of the Treasury during the downtown, and it is now in a position to repay that debt. All of these issues would be positive not only for the individual banks but also collectively. It's signaling to investors that the banking authorities are now more comfortable with the financial condition of these companies and Puerto Rico's economy.

TGR: For Banco Popular, is the improvement in the credit quality the most important factor?

TH: It is. The biggest problem asset class that each of the banks has in Puerto Rico is residential mortgage assets. Similar to the U.S., Puerto Rico has been experiencing a modest rebound in housing, particularly at the lower end of the market. Puerto Rico lagged the U.S. both in the recovery, as well as the downturn. This is certainly not a surprise, but we are seeing ongoing housing improvement. Thus, the banks are becoming that much healthier as we go forward.

TGR: Oriental Financial Group is also processing a merger. How is that going?

TH: Oriental was able to do what we consider to be a transformational merger with Banco Bilbao Vizcaya Argentaria S.A. (BBVA:NYSE). That purchase from the Spanish parent company effectively doubled the size of Oriental, giving it a meaningful delivery channel in the form of branches that it didn't have before. It also provided much-needed diversification to its loan portfolio and its balance sheet so it looks more like a commercial bank than what we've seen in Puerto Rico in the past.

TGR: Do you have a favorite of the three?

TH: I think each one has a fair amount of upside from current levels, but Banco Popular is the one name that stands out. It is now in a great position to move forward by exiting the regulatory orders and repaying the TARP funds. That could have a meaningful impact on the stock price to the positive in the very near term. Once that happens, it's going to send a very positive message to investors as a whole and have a residual benefit to the other banks on the island.

TGR: Do you have any final advice for investors who are either thinking of moving to the island to take advantage of some of the tax benefits or investing in Puerto Rico?

TH: Puerto Rico has long been a very interesting market, but it is also a very misunderstood market because of its commonwealth status. Many U.S. investors are unfamiliar with the laws and how that may impact them as an individual or as a company. But it has a lot of potential, particularly from a manufacturing standpoint. It has a tremendous education system, infrastructure to support a fair amount of growth and programs that have been put in place to stimulate investment and the economy, and underlying job growth. So I think we're in the early innings, but the base has been set for growth going forward. It's just going to take some time.

Nick Giambruno is senior editor at InternationalMan.com. He has lived in Europe and worked in the Middle East. Most recently in Beirut and Dubai, where he worked as a research analyst covering Middle East and North Africa equities for an investment bank. Giambruno is a CFA charterholder and holds a bachelor's degree in finance, summa cum laude.

Alex Daley is the senior editor of Casey's Extraordinary Technology. In his varied career, he's worked as a senior research executive, a software developer, project manager, senior IT executive and technology marketer. He's an industry insider of the highest order, having been involved in numerous startups as an adviser to venture capital companies. He's a trusted adviser to the CEOs and strategic planners of some of the world's largest tech companies. And he's a successful angel investor in his own right, with a long history of spectacular investment successes.

Todd Hagerman joined Sterne Agee in March 2011 to lead the firm's research coverage of the commercial banking sector, primarily focused on U.S. multinational and regional banks. Prior to joining Sterne Agee, Hagerman was head of regional bank equity research at Credit Suisse Securities (USA), where he focused on the regional banking sector. Prior to joining Credit Suisse in 2007, Hagerman spent eight years as a senior banking analyst at Fox-Pitt, Kelton in New York and well more than a decade at the Federal Reserve Bank, which encompassed various roles in bank supervision and regulation at both the Federal Reserve Bank of New York and Federal Reserve Bank of San Francisco. His work at the Fed included various management positions in bank surveillance and review, bank examinations, and policy and special studies. Hagerman holds a Bachelor of Science in finance and economics from the University of Arizona and received his Master of Business Administration from the Marshall School of Business at the University of Southern California.

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DISCLOSURE:
1) The following companies mentioned in the interview are sponsors of Streetwise Reports: None. Streetwise Reports does not accept stock in exchange for its services.
2) Todd Hagerman: I own, or my family owns, shares of the following companies mentioned in this interview: None. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
3) Nick Giambruno: I own, or my family owns, shares of the following companies mentioned in this interview: None. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
4) Alex Daley: I own, or my family owns, shares of the following companies mentioned in this interview: None. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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